2016 is a golden year, literally! The price of New York spot gold rose from $1,050 per ounce at the end of 2015 to $1,300 per ounce this week, a gain of almost 25% in just four months (see the chart below).
Chart excerpted from www.kitco.com as of market close on 5/03/2016.
As many major countries around the world – including Japan, China, France, and England – are printing a lot of money to buttress their economies, global inflation can rise quickly. Because most participants of capital markets are worried about inflation, or worse stagflation, they flock to accumulate gold, bidding up the prices of gold nuggets, jewelries, and futures contracts. In a time like this, most investors should seriously consider having gold as part of their portfolio, because for hundreds of years gold has proven to be one of the strongest hedges against inflation.
Although gold can be an important part of an investor’s portfolio, investing directly in real gold or gold futures may not be suitable for every individual investor. Physical gold products carry high transaction cost, quality risk (it is hard for normal people to assess the true purity of a gold piece), and storage cost and risk, while gold futures have very high investment risk due to high leverage.
For most people, a good alternative is to invest in stocks of gold miners and/or manufacturers of gold products. Because companies mining gold and transforming gold deposits into jewelries enjoy an extra (often very fat) layer of profit for creating value for end-users, their stocks have an extra layer of protection for their bottom line against short-term fluctuations in the price of pure gold.
There are a great many ways to judge the appeal of the stock of a gold company. As an introduction to gold investment and portfolio management, I am going to use a purely systematic and quantitative method to compare several gold stocks in order to give investors a quick feeling for their possible future risk-adjusted performances. Assuming that an investor’s stock portfolio is already well diversified except for not having any gold stock, it should more or less follow the performance of the general market, which I use the S&P index to represent.
Thus, one gauge of a stock’s relative risk for an investor is its correlation and beta to the S&P index. If an investor’s portfolio already has some gold stocks, which I use the SPDR Gold Trust ETF (NYSEARCA:GLD) to represent, an additional gauge of a stock’s relative risk for this investor is its correlation to GLD.
I selected a list of gold stocks that are spread across diverse geographic locations on the globe. The table below shows these stocks’ year-to-date performances, betas and correlations to the S&P 500, and correlations to GLD.
We can see that Kinross Gold Corporation (NYSE:KGC) gives its investors the highest year-to-date capital gain, while Barrick Gold Corporation (NYSE:ABX), AngloGold Ashanti Ltd. (NYSE:AU), and Yamana Gold, Inc. (NYSE:AUY) are not far behind, all showcasing capital gains of more than 100%. As a group, gold stocks have performed superbly so far this year, delivering an average gain of a whopping 90% in just over a quarter of a year. In terms of diversification values, two other stocks stand out. Gold Fields Ltd. (NYSE:GFI) has the lowest beta (a significantly negative one) and close to zero correlation to the S&P.
Again, as a group, gold stocks perform excellently, showcasing very low average correlation to the S&P 500 and an average beta of about zero (meaning that their prices almost completely ignore the direction of the overall stock market and can increase strongly even when the overall stock market is performing poorly). For investors looking for diversification within a gold portfolio, Kingold Jewelry, Inc. (NASDAQ:KGJI) is the answer. KGJI’s stock has a correlation of 0.78 to the GLD index, meaning that about 22% of its movements are unrelated to the ups and downs of gold prices.
In addition to past performances and correlation metrics, investors should also review these companies’ valuation metrics as a guide for possible future gains and potential risks. Note that this assumes that an investor has at least a moderately long investment horizon (i.e. is not a short-term trader that purely chases momentum and technical signals) and believes in value investment and the traditional school of asset valuation (i.e. that companies with similar assets and operations should converge to very close valuation levels over time). The table below shows these gold stocks’ three most important valuation metrics: price-to-earnings, price-to-sales, and price-to-book ratios.
We can see that for the past year, six gold stocks did not earn any net profit. This is understandable, because the price of gold actually dropped last year. It is only since the beginning of this year that the market for gold has started to recover. For investors who trust the most conservative valuation metric, price-to-book value, Goldcorp, Inc. (NYSE:GG) has the lowest ratio and thus is the safest to invest in. For more risk-tolerant investors, Kingold Jewelry has the lowest price-to-earnings and price-to-sales ratios and thus has the potential to appreciate the most if its price-to-earnings or price-to-sales ratio rises to the average of the gold industry.
There is no single answer to the question of which of the aforementioned gold stocks is the best investment. However, one company, Goldcorp, Inc. (Goldcorp), demonstrates several bullish traits and may turn out to be the best performing gold stock this year.
First and foremost, Goldcorp has enjoyed one of the lowest all-in sustaining costs (AISC) among mid-size to large gold producers for years, and it just raised the bar even higher for its competitors in the first quarter. In the first quarter 2016 results, which Goldcorp reported just last week, the company shows that it has lowered its AISC from $885 per ounce a year ago to $836 per ounce. This means that, at a current price of about $1,300 per ounce, Goldcorp is earning a whopping $464 in operating profit per ounce of gold sold. This is why the company shocked the market with a $0.10 EPS in Q1, beating average analysts’ estimates by 150% and completely reversing the result of the $-0.11 EPS in the first quarter of last year.
Secondly, Goldcorp grew its revenue by a huge amount last year and is expecting to sustain its revenue this year. The company produced 3.46 million ounces of gold in 2015. In its Q1 report, the company said that it expected to produce 2.8 to 3.1 million ounces of gold in 2016, but judging by the company’s results over the past several quarters, I believe that the company was overly conservative in its estimate as the trend of its production is not showing any sign of slowing down. In Q4 2015, production grew by 2.1% year over year; in Q1 2016, production grew by 8.1% year over year. Thus, the pace of annual growth in revenue has not slowed down but actually has increased.
Data trend suggests that the company should be able to at least keep its production level steady this year. If this proves to be true, and we assume that Goldcorp can hold its AISC at the current level, it will then earn a decent incremental profit from increased margins in 2016. Furthermore, the company booked a $4.9 million impairment loss in 2015 primarily due to a write-down of the value of inventory amid a huge drop in the market price of its gold reserves.
Since the gold price is rising instead of dropping this year, most of the impairment will be gone in this year’s financial report. For the sake of conservatism, I assume that the company will still book a $1 million impairment loss this year. Taking both factors into consideration, my quant model shows that the company’s bottom line will jump from hell to heaven this year, transforming last year’s loss of $5.03 per share to this year’s profit of $0.68 per share. The calculations are shown in the table below.
We can see in the first table that Goldcorp stock has appreciated only 60% this year, seriously lagging most peers. So far, most investors seem to largely ignore the positive impact of the two factors discussed in this paper on the company’s bottom line. As a result, the market now leaves a significant space for the stock to gain in the remainder of 2016.
When is the best time to buy gold stocks is another difficult question to answer. If we look at the six-month gold price again (shown below), we can see that after experiencing a huge boost at the beginning of the year, the price of spot gold has been fluctuating within a narrower and narrower range. This is a standard flag pattern. With the price now moving to the end of the pattern and the upper bound line converging to the lower bound line, it is time for the price to make a “decision” to break out to either the upside or the downside.
More likely than not, when a material is at the start of a long-term upward trend after reversing from a long-term valley, it will break out to the upside and enjoy a second strong mid-term upward wave. The movement over the past five trading days did confirm this tendency.
For Goldcorp in particular, the market could suddenly “wake up” and fill the gap between the stock’s year-to-date gain and those of its peers. In fact, the first sign of the stock’s revaluation already appeared as it gained 18% last week, the best in the industry for the period. Once the stock’s upward revaluation begins, its daily price appreciation could snowball quickly. Therefore, now is probably the right time to accumulate some gold companies’ shares, and it is a particularly good time to accumulate some of Goldcorp’s.
Disclosure: I am/we are long KGJI.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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